The Eastern Caribbean Currency Union: Would a Fiscal Insurance Mechanism Mitigate National Income Shocks?

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1 WP/12/17 The Eastern Carbbean Currency Unon: Would a Fscal Insurance Mechansm Mtgate Natonal Income Shocks? Antono Lemus and Paul Cashn

2 2012 Internatonal Monetary Fund WP/12/17 IMF Workng Paper Mddle East and Central Asa Department The Eastern Carbbean Currency Unon: Would a Fscal Insurance Mechansm Mtgate Natonal Income Shocks? Prepared by Antono Lemus and Paul Cashn 1 January 2012 Abstract Ths Workng Paper should not be reported as representng the vews of the IMF. The vews expressed n ths Workng Paper are those of the author(s) and do not necessarly represent those of the IMF or IMF polcy. Workng Papers descrbe research n progress by the author(s) and are publshed to elct comments and to further debate. Ths paper studes the nature of the shocks affectng the Eastern Carbbean Currency Unon (ECCU), and examnes whether a hypothetcal Eastern Carbbean fscal nsurance mechansm could nsure member countres of the unon aganst asymmetrc natonal ncome shocks. The emprcal results suggest that a one dollar reducton n an ECCU member country's per capta personal ncome could trgger, through reduced ncome taxes and ncreased transfers, flows equvalent to about 7 percent of the ntal ncome shock. Each member of the currency unon could beneft as well, although the extent of shock mtgaton dffers across ndvdual countres. JEL Classfcaton Numbers: E62, F53, H20, O23 Keywords: Fscal nsurance mechansm; ncome shocks; ncome tax revenue; transfers; Eastern Carbbean Currency Unon Authors E-Mal Addresses: 1 The authors would lke to thank Matas Herrera Dappe, Cleary Hanes, Sam Oulars, Ka Penso, Agustn Rotman, John Rolle, Alfred Schpke, Melesse Tashu, Evrdk Tsounta and semnar partcpants n the IMF s Western Hemsphere Department for ther many useful comments and suggestons.

3 2 Contents Page I. Introducton... 3 II. Nature of the Shocks Affectng the ECCU... 5 III. An ECCU Fscal Insurance Mechansm... 7 IV. Emprcal Estmaton: Regressons n Levels... 7 A. Methodology... 8 B. Results C. Impact on Dsposable Income V. Emprcal Estmaton: Regressons n Growth Rates A. Methodology B. Results VI. Conclusons References Tables 1: Relatve Importance of Symmetrc Versus Asymmetrc Shocks : Temporary Component of Shocks : Income Stablzaton by the Unted States Federal Government : Elastctes of Relatve Transfers and Relatve Income Per Capta : Elastctes of Relatve Income Tax Revenue and Relatve Income Per Capta : Changes n Transfers, Income Tax Revenue and Dsposable Income Per Capta Due to One Dollar Income Shock : Real Average Transfers and Real Average Income Tax Revenue : Growth Rates of Transfers, Income Tax Revenue, and Income Per Capta... 19

4 3 I. INTRODUCTION The Eastern Carbbean Currency Unon (ECCU) s comprsed of eght member countres that share a common currency, monetary polcy, and exchange rate system. 2 3 The common currency, the Eastern Carbbean dollar (EC$), has been pegged to the Unted States dollar (US$) at the rate of EC$2.7 per US$ snce July The common central bank, the Eastern Carbbean Central Bank (ECCB), has operated as a quas-currency board, mantanng foregn exchange backng of ts currency and demand labltes of close to 100 percent. The common monetary polcy mples that each member cannot use ts own ndependent monetary polcy, and n partcular the exchange rate, as an nstrument to mtgate asymmetrc shocks. Shocks can be classfed as symmetrc or asymmetrc, and permanent or temporary. Whle symmetrc shocks can be mtgated by a common monetary polcy, asymmetrc shocks cannot. For ths reason, determnng the nature of shocks s mportant when decdng upon the mtgaton polces to be adopted. If a monetary unon faces an asymmetrc permanent shock, the optmal response s to keep external accounts n balance and reduce aggregate demand. However, f the shock affectng a monetary unon s asymmetrc and temporary, the optmal response s to mantan the level of the aggregate demand and fnance the external gap ether through external debt or foregn reserves. If an asymmetrc shock s not dentfed as ether permanent or temporary, then an ncorrect economc polcy response could be mplemented, wth an unnecessary contracton of aggregate demand when the shock s temporary nstead of permanent, or the unnecessary acquston of new external debt or reducton of foregn reserves when the shock s permanent nstead of temporary. The economc unon lterature suggests that t s the task of the monetary authorty to absorb symmetrc shocks, whle t s the task of each member's fscal polcy to provde nsurance aganst asymmetrc shocks. However, each member's fscal polcy could be neffectve n smoothng cyclcal fluctuatons, because of a lack of fscal space and/or lmted access to credt sources. The creaton of a fscal nsurance mechansm whch collects taxes from the members n a cyclcal upswng to assst those members n a cyclcal downswng could help to ensure the stablty of the economc unon. However, why could a fscal nsurance mechansm be a better soluton than natonal fscal polcy to stablze output? A gven country s fscal polcy could attempt to stablze ncome by runnng defcts durng regonal recessons and surpluses durng regonal booms. Nevertheless, such a polcy s less lkely to 2 The Eastern Carbbean Currency Unon comprses sx IMF member countres: Antgua and Barbuda (ATG), Domnca (DMA), Grenada (GRD), St. Ktts and Nevs (KNA), St. Luca (LCA), and St. Vncent and the Grenadnes (VCT); and two Brtsh terrtores, Angulla and Montserrat. In ths paper we focus on the sx IMF members. 3 For summares of prevous IMF work on the ECCU and wder Carbbean, see Sahay, Robnson, and Cashn (2006) and Bauer, Cashn, and Panth (2008). See IMF (2009a, 2009b) for recent IMF reports on the ECCU, and Pneda, Cashn and Sun (2010) for an analyss of the EC$ real exchange rate.

5 4 be effectve than a fscal nsurance mechansm, because the country s fscal polcy requres that budget defcts be repad by hgher taxes or lower spendng by the same country at some pont n the near future, whle a fscal nsurance mechansm can redstrbute the fscal burden across ts membershp. 4 From a theoretcal perspectve, Alesna et al. (1995) emphasze the exstence of many benefts assocated wth large fscal jursdctons, but at the same tme recognze the exstence of large poltcal and economc costs. In partcular, they argue that when there are two or more dentcal members, except for the fact that ther shocks are not perfectly correlated, a move toward centralzaton of fscal polcy s Pareto superor. In the emprcal lterature whch studes the Unted States federal government as an alternatve mechansm to mtgate shocks, there s a wde range n the estmates of the possble benefts of rsk-sharng, rangng from about 10 percent (von Hagen, 1992) to 38 percent (Sala--Martn and Sachs, 1992) of the ntal shock, explaned by several reasons such as the methodology, the ncluson of redstrbuton and stablzaton effects, and the data used. Sala--Martn and Sachs (1992) fnd that a one dollar reducton n a U.S. regon's personal ncome per capta trggers a decrease n federal taxes of about 34 cents, and an ncrease n federal transfers of 6 cents, resultng n a fnal reducton n dsposable ncome per capta of 60 cents (or about 40 percent of ncome mtgaton). Smlarly, von Hagen (1992) fnds that the Unted States fscal system provdes about 10 percent of ncome mtgaton. Other authors have studed the federal government of the Unted States n ts shock mtgaton role, and, usng alternatve approaches, have obtaned dfferent results. Bayoum and Masson (1995) study the Unted States and Canada (another federal government) usng cross-sectonal and tme-seres evdence, dstngushng redstrbuton and stablzaton effects, decomposng the federal government effect, and capturng the ndvdual effects of transfers and taxes. Asdrubal et al. (1996) descrbe three channels through whch rsk-sharng can occur n a federal regme. Frst, members can share rsk va cross-ownershp of productve assets, though ths requres the exstence of a developed captal market. Second, consumpton can be smoothed by adjustng ther portfolo of assets through lendng and borrowng on natonal credt markets. Thrd, regons can share rsk through a fscal nsurance mechansm that collects taxes from, and provdes transfers to, currency unon members. In ths paper we focus on ths last channel. In ths context, Dos Res (2004) descrbes a fscal nsurance mechansm and supports ts mplementaton for the ECCU. Usng numercal smulatons for partal and full nsurance 4 For addtonal detals n a Carbbean context, see Duttagupta and Tolosa (2006) and Araujo (2009).

6 5 schemes t quantfes the requred sze of the ntal buffer, and smulates the welfare gans n terms of lower volatlty and a lower ntal buffer as compared wth complete self-nsurance. Ths paper ams to: () dentfy the type of shocks affectng ECCU-member countres; () ascertan whether asymmetrc and temporary shocks are an mportant source of rsk for ECCU members; () study whether a hypothetcal Eastern Carbbean fscal nsurance mechansm could nsure ts members aganst asymmetrc ncome shocks; and (v) calculate the mpact of shocks on dsposable ncome per capta. In dong so, we replcate the analyss of Cohen and Wyplosz (1989), run regressons n levels between the changes n ncome and the changes n ncome taxes and transfers, and run regressons n growth rates between ncome, and ncome tax revenue and transfers, for each ECCU member and for the ECCU as a whole. We also propose a scenaro n whch the hypothetcal Eastern Carbbean fscal nsurance mechansm collects taxes from, and provdes transfers to, ts members. We fnd that for the ECCU, symmetrc shocks are quanttatvely more mportant than asymmetrc shocks, and that asymmetrc shocks tend to be more temporary than permanent. Ths mples that an mportant part of the shocks affectng the ECCU members are asymmetrc and temporary, so cannot be readly addressed by a common monetary polcy, and need alternatve mtgaton polces. We also fnd that when the ECCU s ht by a one dollar negatve ncome shock, a hypothetcal ECCU fscal nsurance mechansm would be able to mtgate the effects of that shock, absorbng between 3 and 7 percent of the ntal shock. Fnally, the results from the regressons n growth rates suggest that a hypothetcal Eastern Carbbean fscal nsurance mechansm would provde mtgaton n the amount of 7 percent of the average ncome per capta. The paper contnues as follows. Secton II analyzes the nature of the shocks affectng ECCU member countres, calculates the relatve mportance of symmetrc and asymmetrc shocks, and ther permanent and temporary components. Sectons III, IV and V quantfy the shock-mtgaton potental of a hypothetcal ECCU fscal nsurance mechansm. Fnally, conclusons are presented n Secton VI. II. NATURE OF THE SHOCKS AFFECTING THE ECCU In the economc unon lterature t s well known that asymmetrc shocks (.e., those requrng a dfferent optmal polcy response for each ndvdual member) are a potental threat to unon cohesveness. Ths lterature suggests that asymmetrc and temporary shocks are the most harmful, motvatng a dscusson about alternatve economc polces to address them. In ths secton we analyze the nature of shocks affectng ECCU member countres over the last four decades, calculatng the relatve mportance of symmetrc and asymmetrc shocks, and ther permanent and temporary components. The approach of Cohen and Wyplosz (1989)

7 6 s appled and the varable studed s annual real GDP n constant prces 5 (n mllons of Eastern Carbbean dollars, EC$), for the broadest sample avalable, There are alternatve methods for assessng the symmetry or asymmetry of shocks and for dentfyng and separatng ther permanent and temporary components, such as measures of synchroncty of busness cycles and those derved from vector autoregressve models. We follow the approach of Cohen and Wyplosz (1989), because we only want to compare, and not decompose or separate, the relatve proporton of symmetrc and asymmetrc shocks permanent and temporary components. The approach of Cohen and Wyplosz (1989) proceeds as follows: () report the levels (natural logarthm) of real GDP for each ECCU member wth respect to the whole ECCU, excludng the country concerned n each case; () calculate the sums, whch dentfy the symmetrc shocks, and the dfferences for the asymmetrc shocks; () obtan the standard devaton of the sums and the dfferences; and (v) report the rato between the standard devaton of the sums and the standard devaton of the dfferences. If the rato s greater than one, ths mples that symmetrc shocks are more mportant than asymmetrc ones. To assess the relatve mportance of permanent versus temporary shock components, we: () obtan the permanent and temporary components of the symmetrc and asymmetrc shocks (for ths purpose we use the Hodrck-Prescott flter); () calculate the standard devaton of the temporary components and of the orgnal seres, for the symmetrc and asymmetrc shocks; and () report the rato between the standard devaton of the temporary component and the standard devaton of the orgnal seres, for both symmetrc and asymmetrc shocks. If the rato s relatvely hgh, t ndcates that temporary shocks are more prevalent than permanent shocks. The relatve mportance of symmetrc versus asymmetrc shocks affectng ECCU countres s presented n Table 1. The frst two columns show the sze of the symmetrc and asymmetrc shocks, measured by ther standard devaton, and the thrd column shows the rato between them;.e., symmetrc to asymmetrc shocks. In all the cases the ratos are greater than one, meanng that for all ECCU members, symmetrc shocks are more prevalent than asymmetrc shocks. Table 2 shows the sze of the temporary component of shocks affectng the ECCU, measured by the rato between the standard devaton of the temporary component and the standard devaton of the orgnal seres, for both symmetrc and asymmetrc shocks. The temporary component of symmetrc shocks s only about 5 percent of the total shock; n contrast, the 5 Hgher-frequency data are not avalable for ECCU countres. 6 The source of the data s the IMF s World Economc Outlook.

8 7 temporary component of asymmetrc shocks s about one-thrd of the total shock for all ECCU members (an excepton s St. Vncent and the Grenadnes, where t s about two-thrds of the total shock). These results mply that n spte of the relatve mportance of symmetrc shocks, asymmetrc and temporary shocks are stll mportant, suggestng the need for alternatve economc polces, beyond the common monetary polcy, to mtgate ths type of shock. III. AN ECCU FISCAL INSURANCE MECHANISM In ths secton we replace the present stuaton of the ECCU wth a hypothetcal scenaro n whch the ECCU has a fscal nsurance mechansm responsble for the collecton of taxes from, and the provson of transfers to, ECCU members. As the ECCU s at present a currency unon wth no fscal polcy at the federal level, a key assumpton s needed. We assume that all the actual hstorcal ncome tax revenue collected from, and transfers made to, each member, durng the perod of study, are equal to the respectve amounts that would have been collected and transferred by a hypothetcal fscal nsurance mechansm. We run regressons n levels and n growth rates, to measure the potental ncome-shock-mtgaton benefts that an Eastern Carbbean fscal nsurance mechansm could provde when ts members experence an adverse ncome shock. We choose to run regressons n levels (the approach of Sala--Martn and Sachs (1992)) and n growth rates (the approach of von Hagen (1992)) because these papers are semnal n the economc unon lterature, and they present the most extreme results of ncome stablzaton for the Unted States (as noted earler, Sala--Martn and Sachs (1992) calculate 38 percent and von Hagen (1992) 9 percent ncome mtgaton, respectvely; see Table 3). The data cover the perod , the most comprehensve set of data avalable, and consders the followng varables: GDP at market prces n EC$ mllons; transfers n EC$ mllons (whch ncludes grants and contrbutons, and retrement benefts); ncome tax revenue n EC$ mllons; the consumer prce ndex (CPI); and populaton. 7 The data on GDP at market prces comes from the IMF s World Economc Outlook (WEO), whle the transfers and ncome tax revenue data come from ECCU country authortes. The CPI and the populaton data come from the IMF s Informaton Notce System (INS) and Internatonal Fnancal Statstcs (IFS) databases, respectvely. 7 To measure the mpact on dsposable ncome per capta, we should use personal ncome tax per capta. However, for the majorty of ECCU members these data are not avalable, and so we had to use nstead ncome tax revenue data.

9 8 IV. EMPIRICAL ESTIMATION: REGRESSIONS IN LEVELS Ths secton descrbes the Sala--Martn and Sachs (1992) methodology, presents the regresson results, and calculates the mpact an ncome shock has on the ECCU and on member-country dsposable ncomes. Before proceedng, we analyze the possblty of nonstatonarty by estmatng augmented Dckey-Fuller tests for the dependent and ndependent tme seres studed (relatve transfers per capta, relatve ncome tax revenue per capta, and relatve ncome per capta). 8 We fnd that: () almost all the varables (n levels) are non-statonary, whle ther frst dfferences are statonary; () among the relatve transfers per capta, only Domnca and Grenada exhbt statonary tme seres; () the relatve ncome tax revenue per capta tme seres for Grenada, St. Ktts and Nevs, and St. Vncent and the Grenadnes are statonary; and (v) none of the relatve ncome per capta varables s statonary. Although many of the varables studed are not statonary, we proceed wth the estmaton because, as far as the authors are aware, there s no smlar evdence for the ECCU and ts members. A. Methodology To obtan the reducton n dsposable ncome per capta for an ECCU member country n the presence of an adverse ncome shock, the change n the dsposable ncome per capta s defned as: (1) YD Y TR TX where: YD represents the change n the dsposable ncome per capta of the th ECCU member; Y corresponds to the change n ncome per capta n the th ECCU member; TR s the change n the transfers per capta n the th ECCU member; and TX corresponds to the change n the ncome tax revenue per capta n the th ECCU member. TR TR The ncome per capta-transfers per capta elastcty s defned as TR and the Y Y TX TX ncome per capta-ncome tax revenue per capta elastcty s defned as TX. Y Y The change n dsposable ncome per capta can be expressed as a functon of the change n transfers per capta, ncome tax revenue per capta, ncome per capta and the elastctes just defned, as: 8 These varables are relatve to the correspondng ECCU varable.

10 9 (2) TR TX YD Y Y * TR * Y * TX * Y Y where: LTr Y * TR * TR Y s denoted as the transfers effect and LTx Y * * TX Y s denoted as the taxes effect. TX To obtan the elastctes prevously defned we estmate the followng two-equaton model: (3) ln transfers TR TR ln ncome TR TIME (4) ln taxes TX TX ln ncome TX TIME where: transfers corresponds to the rato between transfers per capta n the th member and transfers per capta n the ECCU as a whole; taxes corresponds to the rato between ncome tax revenue per capta n the th member and ncome tax revenue per capta n the ECCU as a whole; and ncome corresponds to the rato between ncome per capta n the th member and ncome per capta n the ECCU as a whole. The TIME varable represents the trend component of transfers and taxes not explaned by ncome changes. Fnally, TX and TR are the constants of the model, whle and are the errors. In ths setup, TR and TX represent the percentage change n country relatve transfers per capta and country relatve ncome tax revenue per capta, when relatve ncome per capta changes by one percent. As noted above, the model varables are relatve transfers per capta, relatve ncome tax revenue per capta, and relatve ncome per capta. These were obtaned by takng each member country s GDP at market prces, transfers, and ncome tax revenue, deflatng by the CPI and dvdng by the natonal populaton; and then dvdng the correspondng member varable (numerator) by the respectve varable for the whole ECCU (denomnator). As noted by Sala--Martn and Sachs (1992), runnng the regressons n levels has two problems: () smultanety bas; and () heteroskedastcty and/or correlaton n the actual (true) errors terms across members. In spte of these problems, we proceed estmatng the regressons by Ordnary Least Squares (OLS), whch would yeld coeffcents that are downward-based and possbly affected by heteroskedastcy and/or correlaton n the actual error terms across members. To correct for smultanety bas we run regressons usng Instrumental Varables (IV), and the nstruments are the natural logarthm of: the real effectve exchange rate, the real ol prce, ECCU aggregate GDP growth, and tourst arrvals.

11 10 The real ol prce for the ECCU was obtaned by deflatng crude ol prces by the ECCU CPI The real effectve exchange rate was obtaned from the IMF s Internatonal Fnancal Statstcs (IFS) database; the ECCU aggregate GDP growth and tourst arrvals were obtaned from the ECCU country authortes. To partally address the heteroskedastcty problem, we estmate Seemngly Unrelated Regressons (SUR). 11 Also, gven the characterstcs of the data, we run panel data regressons (fxed effects (FE) and random effects (RE)), whch provde an aggregate coeffcent for the ECCU as a whole. B. Results Ths secton presents the results obtaned for the elastctes TR and TX, whch are lsted n Tables 4 and 5. Whle Table 4 reports the elastctes between relatve transfers per capta and relatve ncome per capta ( ), Table 5 presents the elastctes between relatve ncome tax revenue and relatve ncome per capta ( TR TX ). We focus on those coeffcents that are statstcally sgnfcant, and where the mnmum and the maxmum of the 95 percent confdence nterval have the same sgn as the coeffcent. In Table 4, wth the excepton of Antgua and Barbuda, Domnca and the ECCU, none of the TR coeffcents are statstcally sgnfcant. The coeffcents of Antgua and Barbuda are postve, ndcatng a postve relatonshp between relatve transfers per capta and relatve ncome per capta. Addtonally, ndependent of the estmaton method, these coeffcents are greater than one, meanng that a one percent decrease n the relatve ncome per capta mples a more than one percent contracton n the relatve transfers per capta, and ndcate that nsurance mechansm transfers would not help to mtgate ncome shocks n Antgua and Barbuda. 12 On the other hand, the coeffcents of Domnca and the ECCU are negatve, meanng that a decrease n relatve ncome per capta mples an ncrease n the relatve transfers per capta, suggestng that nsurance mechansm transfers could mtgate ncome shocks. 9 The crude ol prce (n U.S. dollars per barrel) corresponds to the smple average of three spot prces; Dated Brent, West Texas Intermedate, and Duba Fateh. Ths nomnal prce was obtaned from the IMF s Internatonal Fnancal Statstcs database. 10 The ECCU CPI s the average of the ECCU members CPI. 11 In the presence of heteroskedastcy and/or correlaton n the true error terms, OLS estmaton yelds unbased coeffcents but a based varance-covarance matrx, affectng the statstcal sgnfcance of the estmated coeffcents. SUR does not correct for heteroskedastcty or correlaton, but does allow for the exstence of dfferent errors n each country equaton. 12 In the OLS and IV cases the confdence ntervals also have postve extreme values, whch confrm the postve relaton.

12 11 In the case of the ncome per capta ncome tax revenue per capta elastctes ( TX ), only Domnca, St. Luca and the ECCU estmated coeffcents are sgnfcant, suggestng postve relatonshps but wth dfferng magntudes. Whle the coeffcents of Domnca and St. Luca are greater than one, evdencng progressve tax systems, those for the ECCU are postve but less than one (Table 5). C. Impact on Dsposable Income Ths secton calculates how much of a negatve ncome shock to an ECCU member country would be absorbed by a hypothetcal ECCU nsurance mechansm, n the form of transfers and ncome taxes. Usng equaton (2), the elastctes n Tables 4 and 5, and the perodaverage share of GDP of transfers and ncome tax revenue (see Table 7), and assumng that the change n ncome per capta s equal to one EC dollar, we calculate (n Table 6) for each ECCU member and for the ECCU as a whole, the assocated change n: ncome tax revenue per capta ( taxes effect ); transfers per capta ( transfers effect ); and the change n dsposable ncome per capta ( YD ). OLS, IV, and SUR regressons provde coeffcents for each country; FE and RE regressons present coeffcents for the ECCU as a whole. Gven the above-mentoned negatve ncome shock, ECCU dsposable ncome per capta (after consderng the transfers and taxes effects), s calculated at 93 cents, mplyng that transfers and ncome tax revenues would mtgate about 7 cents of an adverse one-dollar ncome shock. Addtonally, only consderng the taxes effect, the coeffcents for the ECCU mply a dsposable ncome reducton of 97 cents, and a consequent ncome mtgaton of 3 cents n the dollar (Table 6). At the country level Domnca's dsposable ncome per capta decreases to about 85 cents ths s a better stuaton n comparson wth the orgnal reducton of one dollar. On the other hand, only consderng the transfers effect, Antgua and Barbuda ends up worse off, wth a reducton n ts dsposable ncome per capta of 103 to 111 cents, nstead of the orgnal onedollar negatve ncome shock. Fnally, n an ntermedate but stll better-off case, only consderng the taxes effect, St. Luca could mtgate about 9 cents n the dollar of a negatve ncome shock, wth a decrease of 91 cents n ts dsposable ncome per capta. V. EMPIRICAL ESTIMATION: REGRESSIONS IN GROWTH RATES A. Methodology A fscal nsurance mechansm can serve two dfferent purposes, frst to respond to persstent dfferences n ncome levels and reduce nequaltes among ts members ( redstrbuton effect ), and second to stablze ncome when member countres face temporary negatve ncome shocks, agan redstrbutng ncome among them ( stablzaton effect ). Runnng regressons n growth rates (followng von Hagen (1992)) dstngushes between these two effects, focusng on the second. The varables of study are the growth of: GDP per capta at

13 12 market prces; transfers per capta (whch ncludes grants, contrbutons and retrement benefts), and ncome tax revenue per capta. To measure the responsveness of transfers and ncome tax revenue to changes n the economc condtons, the followng equatons are estmated: (5) TRgrowth TR TR Incomegrowth (6) TXgrowth TX TX Incomegrow th where: denotes the th ECCU member; the th member; member; and member. TRgrowth s the growth of transfers per capta n TXgrowth represents the growth of ncome tax revenue per capta n the th Incomegrow th corresponds to the growth of ncome per capta n the th In equaton (5), TR llustrates the average elastcty of transfers per capta and ncome per capta growth n the th country member. In equaton (6) TX represents the average elastcty of ncome tax revenue and ncome per capta growth n the th country member. As prevously, TR and TX are the constants of the model, and and are the errors. For the ECCU, we estmate pooled OLS regressons whch nclude all the cross secton and tme seres data, and FE and RE regressons. For the ndvdual ECCU members we estmate SUR regressons. B. Results Table 8 shows that the growth of ECCU ncome tax revenue per capta s drectly related wth the growth of ECCU ncome per capta. Ths lnk s statstcally sgnfcant and the coeffcent s about 1.3. Thus, a declne n the ncome per capta growth of one percent leads to a contracton of the growth of the ncome tax revenue per capta of about 1.3 percent. The ECCU growth of transfers per capta does not seem to be related to the growth of ncome per capta. Consderng the statstcal sgnfcance an Eastern Carbbean fscal nsurance tax would provde mtgaton to average ncome per capta of about 7 percent. At the country level, the relatonshp between the growth of transfers per capta and the growth of ncome per capta does not yeld statstcally sgnfcant coeffcents (apart from Grenada). However, the growth rates of ncome tax revenue per capta and ncome per capta do yeld statstcally sgnfcant coeffcents for Antgua and Barbuda, Domnca, St. Ktts and Nevs, and St. Luca, whch are all postve and greater than 1.7, mplyng a postve and greater than proportonal relatonshp. Combnng the sgnfcant results for each ECCU

14 13 country we fnd that an Eastern Carbbean fscal nsurance mechansm would provde mtgaton to average ncome per capta, from the orgnal ncome shock, of 4 percent for Antgua and Barbuda, 11 percent for Domnca, 13 percent for St. Ktts and Nevs, and 11 percent for St. Luca. VI. CONCLUSIONS Ths paper fnds that among the shocks affectng ECCU countres, symmetrc shocks have been quanttatvely more mportant than asymmetrc shocks, but these shocks tend to be more temporary than permanent. These asymmetrc and temporary shocks, the most harmful accordng to the economc unon lterature, are an mportant feature of the ECCU that cannot be addressed by the currency unon s common monetary polcy, mplyng the need for alternatve economc polces. Our fndngs ndcate that an Eastern Carbbean fscal nsurance mechansm could provde shock-mtgaton benefts for the ECCU as a whole, mtgatng about 7 percent of the total negatve ncome shock, and also beng of beneft for the majorty of ts members. Followng Sala--Martn and Sachs (1991) and von Hagen (1992), we found that when ECCU member countres are affected by a one dollar (adverse) ncome shock, an ECCU fscal nsurance mechansm would be able to mtgate the rsk, absorbng on average about 7 cents n the dollar of the ncome shock. Each member of the currency unon could beneft as well, although the extent of shock mtgaton dffers across ndvdual countres. Whle ths paper fnds benefts from an ECCU nsurance mechansm, n comparson wth the Sala--Martn (1991) results for the states of the Unted States, the hypothetcal ECCU nsurance mechansm provdes much smaller levels of country rsk mtgaton. An am of ths nvestgaton s to provde a baselne for quantfyng the effects of an ncome shock on the dsposable ncome of the ECCU and ts member countres. Estmatons usng alternatve emprcal methods awat further nvestgaton.

15 14 Table 1: ECCU: Relatve Importance of Symmetrc Versus Asymmetrc Shocks Symmetrc (1) Asymmetrc (2) Rato (1)/(2) Antgua and Barbuda (ATG) Domnca (DMA) Grenada (GRD) St. Ktts and Nevs (KNA) St. Luca (LCA) St. Vncent and the Grenadnes (VCT) Source: Authors' calculatons. Table 2: ECCU: Temporary Component of Shocks (n percent) Symmetrc Asymmetrc Antgua and Barbuda (ATG) Domnca (DMA) Grenada (GRD) St. Ktts and Nevs (KNA) St. Luca (LCA) St. Vncent and the Grenadnes (VCT) Source: Authors' calculatons. Table 3: Income Stablzaton by the Unted States Federal Government (n percent) Sachs and Sala--Martn (1992) 38 von Hagen (1992) 9-10 Goodhart and Smth (1993) 13 Bayoum and Mason (1995) 17 Asdrubal et al (1996) 30 Obstfeld and Per (1998) 13 Meltz and Zumer (1998) 20 Fatas (1998) 11 Source: Furcer (2004).

16 15 Table 4: Elastctes of Relatve Transfers and Relatve Income Per Capta Dependent varable: ln (relatve transfers per capta) Country β TR t-statstc 95% Confdence Interval Trend R² Adj R² ATG OLS 3.831** ** IV 7.013* * SUR 1.810*** DMA OLS *** * IV ** * SUR GRD OLS * IV * SUR KNA OLS IV SUR LCA OLS IV SUR VCT OLS IV SUR ECCU FE * RE Note: * Statstcally sgnfcant at 99 percent level. ** Statstcally sgnfcant at 95 percent level. *** Statstcally sgnfcant at 90 percent level. Source: Authors calculatons.

17 16 Table 5: Elastctes of Relatve Income Tax Revenue and Relatve Income Per Capta Dependent varable: ln (relatve ncome tax revenue per capta) Country β TX t-statstc 95% Confdence Interval Trend R² Adj R² ATG OLS *** IV *** SUR DMA OLS 1.335*** * IV * SUR 3.105* GRD OLS IV SUR KNA OLS * IV SUR LCA OLS 1.394*** IV SUR 1.459* VCT OLS IV SUR ECCU FE 0.726** RE 0.518*** Note: * Statstcally sgnfcant at 99 percent level. ** Statstcally sgnfcant at 95 percent level. *** Statstcally sgnfcant at 90 percent level. Source: Authors calculatons.

18 17 Table 6: Changes n Transfers, Income Tax Revenue and Dsposable Income Per Capta Due to One Dollar Income Shock Transfers effect Taxes effect Dsposable ncome Country Estmated Mn Max Estmated Mn Max Estmated 1/ Mn Max ATG OLS n.a. n.a. n.a IV n.a. n.a. n.a SUR n.a. n.a. n.a DMA OLS IV SUR n.a. n.a. n.a GRD OLS n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. IV n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. SUR n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. KNA OLS n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. IV n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. SUR n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. LCA OLS n.a. n.a. n.a IV n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. SUR n.a. n.a. n.a VCT OLS n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. IV n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. SUR n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. ECCU FE RE n.a. n.a. n.a / Dsposable ncome per capta ncludes only the transfers effect for ATG and the ECCU RE, only the taxes effect for LCA, and both effects for DMA. n.a.: Not avalable due to statstcal nsgnfcance of elastctes calculated n Tables 4 and 5.

19 18 Table 7: Real Average Transfers and Real Average Income Tax Revenue, (n percent of GDP) Transfers Income tax revenue Antgua and Barbuda (ATG) Domnca (DMA) Grenada (GRD) St. Ktts and Nevs (KNA) St. Luca (LCA) St. Vncent and the Grenadnes (VCT) ECCU Source: Authors' calculatons.

20 19 Table 8: Growth Rates of Transfers, Income Tax Revenue, and Income Per Capta Dependent varable: Growth rate of transfers per capta Country β TR t-statstc 95% Confdence Interval R² ATG SUR (0.59) DMA SUR (0.31) GRD SUR (1.78) KNA SUR (0.53) LCA SUR (0.95) VCT SUR (-0.82) OLS (0.15) ECCU FE (0.17) RE (0.15) Dependent varable: Growth rate of ncome tax revenue per capta Country β TX t-statstc 95% Confdence Interval R² ATG SUR 1.802** (2.59) DMA SUR 1.775** (2.36) GRD SUR (0.92) KNA SUR 2.067* (5.12) LCA SUR 1.789* (3.54) VCT SUR (-1.55) OLS 1.332* (3.61) ECCU FE 1.354* (3.52) RE 1.332* (3.61) Note: * Statstcally sgnfcant at 99 percent level. ** Statstcally sgnfcant at 95 percent level. Source: Authors calculatons.

21 20 References Alesna, A., R. Perott and E. Spolaore, 1995, The Poltcal Economy of Fscal Dscplne: Together or Separately? Issues on the Costs and Benefts of Poltcal and Fscal Unons, European Economc Revew, Vol. 39, pp Araujo, J., 2009, Fscal Cycles n the Carbbean, IMF Workng Paper 09/158 (Washngton: Internatonal Monetary Fund) Asdrubal P., B. Sorensen and O. Yosha, 1996, Channels of Interstate Rsk Sharng: Unted States , The Quarterly Journal of Economcs, pp Bajo-Rubo, O. and C. Daz-Roldan, 2005, Vulnerablty to Shocks n the EMU: , Workng Paper on Internatonal Economcs and Fnance 04 02, AEEFI-FEDEA. Bajo-Rubo, O. and C. Daz-Roldan, 2006, Characterzng Macroeconomc Shocks n the CEECs, Economc Change, Vol. 38, pp Bayoum, T. and P. Masson, 1995, Fscal Flows n the Unted States and Canada: Lessons for Monetary Unon n Europe, European Economc Revew, Vol. 39, pp Bayoum, T. and P. Masson, 1998, Lablty-Creatng versus Non-Lablty-Creatng Fscal Stablzaton Polces: Rcardan Equvalence, Fscal Stablzaton, and EMU, The Economc Journal, Vol. 108, pp Bauer, A., P. Cashn and S. Panth, 2008, The Carbbean: Enhancng Economc Integraton (Washngton: Internatonal Monetary Fund) Bean, C., 1992, Economc and Monetary Unon n Europe, Journal of Economc Perspectves, Vol. 6, pp Bureau, D. and P. Champsaur, 1992, European Economc Integraton: Where Do We Stand? Fscal Federalsm and European Economc Unfcaton, AEA Papers and Proceedngs, Vol. 82, pp Cohen, D. and C. Wyplosz, 1989, The European Monetary Unon: An Agnostc Evaluaton, n Bryant R. et al, eds., Macroeconomc Polces n an Interdependent World (Washngton: Internatonal Monetary Fund) pp Dos Res, L., 2004, A Fscal Insurance Proposal for the Eastern Carbbean Currency Unon, XVIII G24 Techncal Group Meetng, Geneva (March).

22 21 Duttagupta, R. and G. Tolosa, 2006, Fscal Polcy: Is the Eastern Carbbean Currency Unon a Free-Rdng Paradse? In R. Sahay, D. Robnson, and P. Cashn, eds., The Carbbean: From Vulnerablty to Sustaned Growth (Washngton: Internatonal Monetary Fund), pp Fatas, A., 1998, Does EMU Need A Fscal Federaton? Economc Polcy, Vol. 26, pp Furcer, D., 2004, Does the EMU Need A Fscal Transfer Mechansm? Verteljahrshefte zur Wrtschaftsforschung, Vol. 73, pp Goodhart, C., and S. Smth, 1993, Stablzaton, European Economy: Reports and Studes, Vol. 5, pp Greene, W., 2003, Econometrc Analyss, Ffth edton, Upper Saddle Rver, New Jersey: Prentce Hall. Internatonal Monetary Fund, 2009a, Eastern Carbbean Currency Unon: 2009 Dscusson on Common Polces of Members Countres - Staff Report, IMF Country Report No. 09/175, (Washngton: Internatonal Monetary Fund). Internatonal Monetary Fund, 2009b, Eastern Carbbean Currency Unon: Selected Issues, IMF Country Report No. 09/176, (Washngton: Internatonal Monetary Fund). Masson, P., 1996, Fscal Dmensons of EMU, The Economc Journal, Vol. 106, pp Meltz, J., 2004, Rsk Sharng and EMU, Journal of Common Market Studes, Vol. 42, pp Meltz, J. and F. Zumer, 1998, Regonal Redstrbuton and Stablzaton by the Center n Canada, France, the Unted Kngdom, and the Unted States, Dscusson Paper 1829, (London: Center for Economc Polcy Research). Obstfeld, M. and G. Per, 1998, Regonal Nonadjustment and Fscal Polcy, Economc Polcy, Vol. 26, pp Pneda, E., P. Cashn, and Y. Sun, 2010, Assessng Exchange Rate Compettveness n the Eastern Carbbean Currency Unon, Journal of Busness, Fnance and Economcs n Emergng Economes, Vol. 5, pp

23 22 Sahay, R., D. Robnson and P. Cashn, 2006, The Carbbean: From Vulnerablty to Sustaned Growth, (Washngton: Internatonal Monetary Fund). Sala--Martn, X. and J. Sachs, 1991, Fscal Federalsm and Optmum Currency Areas: Evdence for Europe from the Unted States, NBER Workng Papers Seres, Workng Paper 3855, Cambrdge, MA. Sala--Martn, X. and J. Sachs, Fscal Federalsm and Optmum Currency Areas: Evdence for Europe from the Unted States, n Canzoner M., Grll V. and Masson P., eds., Establshng a Central Bank: Issues n Europe and Lessons from the U.S., Cambrdge Unversty Press, Cambrdge, MA. Tapsoba, S., 2010, West Afrcan Monetary Integraton and Interstate Rsk-Sharng, Journal of Economc and Monetary Integraton, Vol. 9, pp von Hagen, J., 1992, Fscal Arrangements n a Monetary Unon: Evdence from the U.S., n D. Far and C. de Bosseu, eds., Fscal Polcy, Taxaton, and the Fnancal System n an Increasngly Integrated Europe, Boston, MA: Kluwer. von Hagen, J. and B. Echengreen, 1996, Europe s Moneys and European Insttutons: Federalsm, Fscal Restrants, and European Monetary Unon, AEA Papers and Proceedngs, Vol. 86, pp

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